Thursday, June 16, 2011

How Deregulation Hurts the Economy

Suppose that gambling were illegal. That restriction would be a governmental regulation. Then suppose that the government legalized gambling. That would be a deregulation.

Gambling can have victims, such as a gambler’s family, when the gambler squanders his earnings on games of chance rather than feed and house his family. Suppose then to avoid the deprivation to family members, the government bailed out gamblers. The government would give losing gamblers back their money, to avoid possible harm to their families.

What would be the result? Obviously there would be a huge amount of gambling. If one wins, one keeps the gains. If the gambler loses, he gets back his losses. The great increase in gambling would generate a huge amount of government spending in bailing out the gamblers who statistically would lose more than half the time.

The resulting huge increase in government spending would either stifle the economy with higher taxes or else generate an ever greater government debt. Either result would hurt the economy.

But which policy caused the damage? Is it the deregulation of legalizing gambling, or is it the subsidy to gambling? Clearly the damage to the economy would be caused by the subsidy. Without a subsidy, gambling could hurt individual families, but not the whole economy. The subsidy to gambling would generate major damage to the whole economy as deficits escalated, raising interest rates, reducing investment and growth, and ultimately resulting in a debt default.

The deregulation of the financial industry is similar to the deregulation of gambling. When speculators bear their own losses, this does not damage the economy as a whole. But when government bails out the losing speculators, that causes “moral hazard,” the taking on of excessive risk because the speculators know the government will share the losses.

Many journalists, politicians, and (sadly) economists have blamed the Crash of 2008 on deregulation. That makes it seem like there are no regulations, that anything goes, in finance. But in fact, there was only a small amount of loosening of restrictions on financial affairs. The Federal Reserve system was still there, regulating the banks. The FDIC was there providing deposit insurance as well as further regulation. The SEC was there regulating stocks and bonds to allegedly protect the public. The Community Reinvestment Act was still in force imposing yet more regulation. The Sarbanes-Oxley Act of 2002 had been enacted several years prior to the crash to regulate accounting. The FHA as well as the government-sponsored enterprises Fannie Mae and Freddie Mac regulated mortgages. State governments regulated insurance companies. Both the state and federal governments prohibited and regulated fraud.

Whatever freedom that banks, brokerage firms, insurance companies, mutual funds, hedge funds, and pension funds had to invest and speculate was not the cause of the “Great Recession” and financial crisis, just as the freedom to gamble does not bring down a whole economy. The cause of the recession and financial break-down was the enormous subsidies to the financial firms and to real estate holding. When AIG, Fannie Mae, banks, and others lost money on their mortgages and land-value derivatives, the federal government gifted them back much of their losses. Some of the funds have been paid back, but still, the fact that government will bail out a speculator makes him speculate too much, causing damage to the many homeowners and investors who do not get bailed out.

The regulation of fraud by the SEC did not prevent billions of dollars of ponzi-scheme fraud, despite warnings. One of the problems of regulation is that the bureaucrats end up serving the regulated industries. Economists call this “regulatory capture.” It is also referred to as a revolving door, as the regulators come from the regulated industry and return to it after having served the “regulated” special interests.

Regulations can either be market-enhancing or market-hampering. Marketizing regulations help make the economy more voluntary by prohibiting theft, and with liability rules making those who cause damage to compensate the victims. Interventionist regulations alter what would otherwise be honest and peaceful human actions. The deregulation of previous interventions is market-enhancing, and promotes prosperity if not linked to subsidy.

Public finance theory emphasizes the deadweight loss of the taxation of labor, capital goods, and funds, but subsidies are an even worse economic problem. Subsidies are pernicious because they have the appearance of helping, but have the implicit reality of being weapons of economic mass destruction.

The greatest subsidies are those least visible. The most vicious of all subsidies is the implicit subsidy to real estate, specifically land value, caused by public works and civic services not paid for by landowners. Governmental goods - streets, parks, transit, security, schooling, welfare aid - makes locations more productive, attractive, or affordable, generating higher rent and land value. The payment for these works by the affected landowners would take land values back down, but today the funding is almost all from taxing labor and capital.

This massive subsidy to land values redistributes wealth from workers to landowners, and even worse, generates speculation in real estate that carries prices beyond what can be afforded by households and enterprise. That makes investment stop, and then the economy falls.

The focus on deregulation is an example of people looking only at the superficial appearance, and not understanding the implicit reality. The main task of economics is indeed to enable people to understand the implicit reality beneath superficial appearances. The sad fact that even many economists are mesmerized by superficial appearance shows that most economists are not doing their most essential job.

Sunday, June 05, 2011

The Conformal Economy

In his book Cycles of Time, Roger Premrose carries further his analysis of the geometry of the universe, mathematical and geometric models of black holes and the origin of our universe. In this book, Premrose investigates the geometry of the big bang origin as well as providing a hypothesis about the ultimate fate of the universe. Will the universe continue to expand indefinitely, or does it go through cycles in which expansion is followed by contraction?

The explanation by Premrose is “conformal cyclic cosmology.” A geometry is conformal if its angular structure does not change when the distances are expanded or contracted. Consider a cube with a side of one meter. If we expand it to sides of ten meters, it is still a cube, with the same structure, thus conformal.

Because the early universe is conformal to the current universe, with the same physical laws and geometric structures, and the future expansion is also conformal. While one needs to be savant in physics to understand the Premrose hypothesis, the essential proposition is that the conformal geometry will cause the universe to stop expanding and again contract in an infinite cycle. The hypothesis is not yet a theory since it has not yet been tested by evidence.

There are geometries in economic theory, such as supply and demand curves, the production possibility curve, production functions, circular flows, and the histogram model of the law of rent. But there is also a geometry of the actual economy. This economic geometry is not a physical structure such as the angles of the hydrogen atoms in a water molecule, but rather an economic structure that is hidden from superficial appearance but forms an implicit reality.

The key economic geometry consists of the surplus generated by production. Neoclassical economics models this as a “producer surplus,” geometrically illustrated by a supply curve, a price line, and the area between the price line and the supply curve. That is the so-called “producer surplus”. You can see this visually in a web images search for “producer surplus.”

But neoclassical economics also understands that the long-run economic profits of firms in competitive industries is zero, after subtracting all costs, including normal returns to assets. Thus the “producer surplus” is an economic profit that does not go to the firm owner. It also does not go to wages if the labor market is competitive, as wages greater than normal will increase the supply of labor and drive the wage back down to normal.

The only other place that the surplus can go to in competitive markets is to land rent. Most of the “producer surplus” of an economy is land rent. Since no human being creates land, the title holders are not producers, but only receivers, and so it should be called a “non-producer surplus”.

As a surplus, land rent can be tapped for public revenue without hurting production and investment; indeed, the collection of land rent for public revenue is better than neutral, as the payment is based on the most productive use of land, pushing land to its most productive use.

A pure free market requires that the land rent be collected and distributed equally to all residents in the relevant community, either as cash or as public goods, including services. The equal sharing of land rent is the economic geometry of prosperity, economic justice, and sustainability.

But governments today have altered the economic angles of the surplus from production. They let title holders expropriate the rent, while imposing a tax cost on labor and capital. The geometry of destructive taxation is to shift up supply curves, making production more expensive, and to create a deadweight loss, a misallocation and waste of resources that reduces the surplus from both production and consumption.

Even worse, perverse taxation alters the dynamic geometry of economic growth. Much of the gains from economic expansion are captured by higher rents and therefore higher land values. Speculators buy plots of land to gain from the higher rent, and sometimes keep land in suboptimal use, thus pushing out margins of production to less productive margins, a perverse geometry that reduces wages and increases rent even more. This is malspeculation, a destructive land grab caused by massive governmental subsidies to real estate as artificially cheap credit and as fiscal subsidies, public goods paid for by taxing wages generates higher land values.

Meanwhile, to prevent inflation, the monetary authority reduces its excessive money expansion, so interest rates rise with the greater demand for investment and speculation. The dysfunctional economic geometry of malspeculators seeking large gains from leverage, using other people’s money, escalates land values to geometric heights that make real estate unaffordable by those seeking dwellings and work space. The most optimistic speculators see the geometry of ever rising land values and cannot judge when the peak will occur.

Comes then the stoppage of investment, as land value stop rising, the malspeculators panic and sell, and real estate prices crash, which also collapses the financial structure that is tethered to real estate loans and derivatives.

The fundamental geometric structure of the economies of the world have been conformal, unchanged for the past two hundred years. The growth of government regulations, institutions, and taxes are but a change in the size of geometric structures. None of the private and governmental developments of the past 200 years have changed the angles of the basic economic geometry - the private appropriation of the surplus, and the taxation of production.

The conformal economy results in an economic cycle of boom and bust. Malspeculation caused by the governmental subsidy to real estate creates an unsustainable boom, followed by the recession and depressed economy. Only a fundamental change in the economic geometry can eliminate the boom-bust cycle. That change is to stop taxing production and shift to public revenue from land rent.

The pure free market is like a cube whose lines form right angles. Government intervention - destructive restrictions and taxes - are like force applied to the cube to squeeze and twist it to create odd unstable angles. An efficiency tax shift to stop taxing production and consumption, and instead tap the rent surplus, will result in an economic geometry like the right angles of a cube, the sustainable, efficient, equitable and elegant economic geometry of the pure free market.